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Collateral Margining in Arbitrage-Free Counterparty Valuation Adjustment including Re-Hypotecation and Netting

  • Damiano Brigo
  • Agostino Capponi
  • Andrea Pallavicini
  • Vasileios Papatheodorou

This paper generalizes the framework for arbitrage-free valuation of bilateral counterparty risk to the case where collateral is included, with possible re-hypotecation. We analyze how the payout of claims is modified when collateral margining is included in agreement with current ISDA documentation. We then specialize our analysis to interest-rate swaps as underlying portfolio, and allow for mutual dependences between the default times of the investor and the counterparty and the underlying portfolio risk factors. We use arbitrage-free stochastic dynamical models, including also the effect of interest rate and credit spread volatilities. The impact of re-hypotecation, of collateral margining frequency and of dependencies on the bilateral counterparty risk adjustment is illustrated with a numerical example.

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File URL: http://arxiv.org/pdf/1101.3926
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Paper provided by arXiv.org in its series Papers with number 1101.3926.

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Date of creation: Jan 2011
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Handle: RePEc:arx:papers:1101.3926
Contact details of provider: Web page: http://arxiv.org/

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  1. Damiano Brigo & Mirela Predescu & Agostino Capponi, 2010. "Credit Default Swaps Liquidity modeling: A survey," Papers 1003.0889, arXiv.org, revised Mar 2010.
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